Escalating Political Tension Leads To Increased Volatility In Turkish Economy

Financial markets in Turkey woke up to an unanticipated day on December 17, 2013. There was a probe shaking the country, as prosecutors and police started an investigation which targeted local businessmen and the sons of three ministers, accusing them of being involving in a bribery and corruption case. This investigation revealed a scandal, shook the government and has led to a cabinet reshuffle within the government. The Turkish government and economy are still struggling with this political scandal, and it has significantly rattled the country's financial markets.

After the operation by police against the suspects in the corruption probe, the financial markets were shattered and companies registered in the main index, the Borsa Istanbul (BIST) and Istanbul Stock Exchange, followed in the US by the iShares MSCI Turkey ETF (NYSEARCA:TUR), lost roughly 10 percent of their values. One week later, at of the start of the bribery and corruption probe, losses to the companies registered in the BIST reached approximately $30 billion.

Why did Turkey's stock index show such a rigorous reaction?

The Turkish stock market tends to be more sensitive to political situations than other stock markets. This is an emerging market characteristic, and shows itself in Turkey more often than developed countries. Rather than profits of companies, investors are focused primarily on political stability and the future of the government. This is why the publicly traded Turkish companies were hit so hard by news of corruption. Investors knew that the scandal would end up with political turmoil, a cabinet reshuffle or possibly more.

Along with the corruption scandal, the Turkish Lira was also being hit and had decreased significantly. The Lira was being impacted by the Federal Reserve's meeting on the reduction of its stimulus policy, dropping the value of the Lira into the fire along with the majority of emerging markets' currencies. A pressure on interest rates started immediately to build, but Turkey's Central Bank insisted on not intervening or using monetary policy to change interest rates. The priority of the government is growth, and so, Turkey's Central Bank has been reluctant to use monetary policy adjustments frequently. But with the falling value of the Lira against the US dollar and euro, Turkey's Central Bank could no longer insist on its interest rate policy and had to increase rates. In late January, borrowing rates were hiked from 3.5 to 8 percent, and it increased the lending rate at the same time from 7.75 to 12 percent in an attempt to stop its currency's steep fall.

Besides turmoil in financial markets, figures related to the country's main economic indicators were not hopeful. Turkey's unemployment rate had been increasing and was at the edge of a double-digit percentage, standing at 9.9 percent. In addition, the country's foreign trade deficit was increasing. Turkey's current account deficit problem is becoming more and more serious. The escalating value of foreign currencies against the Lira endangers Turkey's producers' ability to continue their operations at profitable levels. Turkey relies heavily on imports to be able to produce its goods and services, with most raw materials imported from abroad. The dropping value of the Lira will ultimately decrease the competitiveness of Turkish companies due to increasing costs, and may significantly harm the emerging and fast-growing economy.

Figuressignaling a deteriorating real sector and credit ratings

In addition to the developments above, credit rating agencies immediately started making statements regarding the stability of Turkey's credit ratings. First, in early January, Moody's pointed out the political instability, but said that Turkey's domestic political risk was already embedded in the country's current rating, which is Baa3/stable. The most recent change was an increase in Turkey's sovereign credit rating to investment-grade in May 2013. The credit rating agency also mentioned the balance of payment, public finance of the country, foreign capital flows and added that, "A decrease in political risk in Turkey would not be enough to push the country's credit rating upward if no other improvements are attained."

Fitch, which had assigned Turkey a credit rating of "BBB minus" with a stable outlook, followed Moody's by making a statement late January stating that increasing interest rates in Turkey would decrease the sovereign's vulnerability to short-term capital outflows and could ease pressure on the Turkish Lira and reserves. The agency also noted that "a more stable Lira would lessen banks' foreign exchange risks resulting from the foreign exchange market lending to sometimes un-hedged corporate borrowers."

And finally, in early February 2014, Standard & Poor's revised Turkey's economic outlook, cutting its outlook to negative on its unsolicited "BB+" long-term foreign currency and "BBB" long-term local currency ratings. The main reasons shaping the S&P's decision were risks of a hard economic landing and a less predictable policy environment. S&P said in a statement that, "Turkey appears to have suffered an unanticipated erosion of institutional checks and balances and governance standards."

Conclusion

Today, interest rates are higher than predicted, companies in the BIST are less valuable and the Turkish economy is much more fragile. Domestic and foreign investors are mainly focused on political stability, and every piece of news from the political front is affecting the economy and the value of Turkey's publicly traded companies. Political turmoil in Ukraine, and Russia's potential to intervene have also emerged as external factors affecting the emerging country's financial markets.

Local elections in Turkey will be held on March 30, 2014, with many investors awaiting the conclusions of these elections, including the credit rating agencies. Looming elections may deter investors from positioning for the long term, so local political instability and external political risks will be the main factors shaping investors' decisions in the near future. In addition, the Turkish markets will also follow the US and track the Fed's decisions and main economic indicators more closely.

Risks carried by the Turkish economy are increasing by the day, with financial markets becoming more fragile. Credit rating agencies have taken notice and are making their feelings known, and appear to be following the Turkish economy more closely. Investors should heed caution when thinking about taking a position in TUR at this point, and investors who already have exposure in this market should be prepared for instantly changing markets and increased volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.